B40 2302 class 8
Download
1 / 57

B40.2302 Class 8 - PowerPoint PPT Presentation


  • 141 Views
  • Uploaded on

B40.2302 Class #8. BM6 chapters 16.5-16.8,18.1-18.3,18.5,19 16.5-16.8: Dividend relevance under taxes etc. 18.1-18.3, 18.5: Capital structure relevance under taxes and financial distress 19: Valuation under financing effects Based on slides created by Matthew Will

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'B40.2302 Class 8' - maribeth


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
B40 2302 class 8 l.jpg
B40.2302 Class #8

  • BM6 chapters 16.5-16.8,18.1-18.3,18.5,19

    • 16.5-16.8: Dividend relevance under taxes etc.

    • 18.1-18.3, 18.5: Capital structure relevance under taxes and financial distress

    • 19: Valuation under financing effects

  • Based on slides created by Matthew Will

  • Modified 10/31/2001 by Jeffrey Wurgler


Slides by matthew will jeffrey wurgler l.jpg

Principles of Corporate Finance

Brealey and Myers Sixth Edition

  • The Dividend Controversy

Slides by

Matthew Will, Jeffrey Wurgler

Chapter 16.5-16.8

Irwin/McGraw Hill

  • The McGraw-Hill Companies, Inc., 2000


Topics covered l.jpg
Topics Covered

  • Views on dividend relevance

    • The “Rightists” (dividends increase value)

    • The “Radical Left” (dividends decrease value)

    • The “Middle-of-the-Roaders” (little or no effect)


Dividends increase value l.jpg
Dividends Increase Value

A “rightist” (high-payout) view

… the considered and continuous verdict of the stock market is overwhelmingly in favor of liberal dividends as against niggardly ones…

Benjamin Graham and David Dodd

Security Analysis(1951) (1st ed. 1934)


Dividends increase value5 l.jpg
Dividends Increase Value

Rightist argument: M&M ignore risk

  • Dividends are cash in hand, but capital gains are not

  • “Bird in hand versus bird in bush”

  • So isn’t the dividend to be preferred?

    Questionable argument

  • Declaring high dividend makes (residual) capital gain component more risky, overall risk to shareholders does not change

  • Can get dividend-like “bird in hand” whenever you like, just by selling some of your stock

  • M&M assume efficient capital market: $1 in dividend would otherwise be capitalized at $1 in share price. So long as this is true, the “bird in hand” argument is invalid. If this is not true (as Graham and Dodd imply), argument is valid.


Dividends increase value6 l.jpg
Dividends Increase Value

Rightist argument: There are “clienteles” that prefer dividends

  • Some financial institutions cannot hold stocks that do not have established dividend records

  • Trusts and endowments may be discouraged from spending capital gains (which may be viewed as “principal”) but allowed to spend dividends (may be viewed as “income”)

  • Retirees(?)/Small investors(?) may prefer to spend from their AT&T dividend checks rather than sell a few shares every month. (Reduces transaction costs, inconvenience)

  • Corporations pay corporate income tax on only 30% of dividends they receive, but 100% of capital gains.

  • The demand of these “dividend clienteles” may increase the price of a dividend-paying stock

    But…

  • Unclear whether any particular firm can benefit by increasing dividends. There may already be enough high-dividend stocks to choose from.


Dividends increase value7 l.jpg
Dividends Increase Value

Rightist argument: Dividends can’t be wasted

  • Investors may not trust managers to invest retained earnings wisely

  • Firms that refuse to pay out cash may sell at a discount

    Comments

  • In this case dividend decision is tied to investment decision

  • May have particular merit in countries with poor corporate governance systems


Dividends decrease value l.jpg
Dividends Decrease Value

Leftist (low-payout) argument: Taxes

  • If dividends are taxed more heavily than capital gains, investors dislike dividends.

  • Firms should pay low dividend, retain cash or repurchase shares

  • Investors should require higher pre-tax return on dividend-paying stocks (i.e, dividend-paying stocks sell at a discount price)


Dividends decrease value9 l.jpg
Dividends decrease value

Effect of investor taxes (50% dividend, 20% capital gain)

on share prices and returns


Dividends decrease value10 l.jpg
Dividends decrease value

1998 Marginal Income Tax Brackets

  • Dividends are taxed at the personal income rate

  • Capital gains are, for most investors, taxed at 28%

  • High-tax-bracket investors therefore still prefer capital gains


Dividends decrease value11 l.jpg
Dividends decrease value

  • Empirical evidence on dividends, prices, returns:

    • Mixed.

    • Generally a positive relationship between dividend yield and pre-tax returns, as predicted by “leftists”

    • But statistically unreliable


Middle of the road l.jpg
Middle of the road

  • Maybe M&M conclusion of irrelevance is right even when some of the assumptions are relaxed:

    • High- or low-payout clienteles may exist, but they are already satisfied, so no firm can increase its value by changing dividends

    • This “middle of the road” view argues that dividends have little or no effect on value


Slides by matthew will jeffrey wurgler13 l.jpg

Principles of Corporate Finance

Brealey and Myers Sixth Edition

  • How Much Should a Firm Borrow?

Slides by

Matthew Will, Jeffrey Wurgler

Chapter 18.1-18.3, 18.5

Irwin/McGraw Hill

  • The McGraw-Hill Companies, Inc., 2000


Topics covered14 l.jpg
Topics Covered

  • Corporate Taxes

  • Corporate and Personal Taxes

  • Costs of Financial Distress

    • Financial distress games

  • The “trade-off theory” of capital structure


Corporate taxes l.jpg
Corporate Taxes

  • Main advantage of debt in U.S.:

    • Corporations can deduct interest

    • Whereas retained earnings and dividends are taxed at the corporate level

    • Thus, more cash left for investors if firm uses debt finance


Corporate taxes16 l.jpg
Corporate Taxes

Example – Firm U is unlevered, firm L is levered. Firms have same investment policy (so same operating cash flows).

U L

EBIT 1,000 1,000

Interest Pmt 0 80

Pretax Income 1,000 920

Tax @ Tc= 35% 350 322

Net Income to shhs $650 $598

Net to bhhs 80

Total to investors 650 678

Interest tax shield (.35*interest) 28


Corporate taxes17 l.jpg
Corporate Taxes

  • What is present value of tax shield?

    • If the same savings occur every year, value as a perpetuity

    • If the savings are as risky as the debt, discount at cost of debt

    • Under these assumptions:

PV of Tax Shield =

D x rD x Tc

rD

= D x Tc

Example (D = 1000, rD=.10, Tc=.35):

Yearly savings = 1000 x (.10) x (.35) = $35

PV Perpetual Tax Shield @ 10% = 35 / .10 = 1000*.35 = $350


Corporate taxes18 l.jpg
Corporate Taxes

Taxes don’t change the total size of the pretax “pizza.”

  • But now the government gets a slice.

  • Government’s slice is smaller (and investors’ slices are bigger) when debt is used.

  • M&M proposition I with corporate taxes:

    Firm Value = Value of All Equity Firm

    + PV(Tax Shield)

  • … and in special case where debt is permanent …

    Firm Value = Value of All Equity Firm + Tc*D


Corporate taxes19 l.jpg
Corporate Taxes

  • So why not 100% debt, then, or close to it?

    • Maybe looking at corporate and personal taxation will uncover a personal tax disadvantage to borrowing (to offset the corporate tax advantage)

    • Or, maybe firms that borrow incur other costs – such as costs of financial distress – that offset interest tax shield


Corporate and personal taxes l.jpg
Corporate and Personal Taxes

TCCorporate tax rate

TPPersonal tax rate on interest income

TPEPersonal tax rate on Equity income (= TPif all equity income comes in form of cash dividends, but < TP if comes as capital gains, << if they are deferred)

---------------------------------------------------------------------------

$1 in operating income paid as interest:

= $(1 – TP) to bondholder (escapes corporate tax)

$1 in operating income paid as equity income:

= $(1 – TPE)*(1 – TC) (hit by corporate tax, then personal tax)


Corporate and personal taxes21 l.jpg
Corporate and Personal Taxes

Relative Tax Advantage of Debt over Equity

1-TP

=

(1-TPE)*(1-TC)

Tax advantage

RA > 1 Debt

RA < 1 Equity


Corporate and personal taxes22 l.jpg
Corporate and Personal Taxes

Example 1

  • Interest Equity income

Income before tax 1.00 1.00

Corp taxes Tc=.35 0.00 0.35

To investor 1.00 0.65

Pers. taxes TP =.40, TPE=.10 0.40 0.065

Income after all taxes 0.60 0.585

RA = 1.025

 Advantage: Debt (barely)


Corporate and personal taxes23 l.jpg
Corporate and Personal Taxes

Example 2

  • Interest Equity income

Income before tax 1.00 1.00

Corp taxes Tc=.35 0.00 0.35

To investor 1.00 0.65

Pers. taxes TP =.40, TPE= 0 0.40 0.00

Income after all taxes 0.60 0.65

RA = 0.923

 Advantage: Equity


Corporate and personal taxes24 l.jpg
Corporate and Personal Taxes

  • So then … equity or debt? Merton Miller’s argument:

  • Suppose TPE= 0 and TP varies across investors. Then

    • Economy-wide tax-minimizing mix of debt and equity depends on distribution of personal tax rates

    • But there still may be are no tax gains left for individual firms to get by varying their own leverage

      • “Low-tax” investors already hold all the bonds they want

      • If “marginal investor” has high tax rate, may be no tax gain left from issuing debt to him!

      • Current tax law still seems to favor borrowing, though

      • (TPEnot as low as Miller assumed)


Costs of financial distress l.jpg
Costs of Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions on the brink of bankruptcy.

Firm value = Value of All Equity Firm

+ PV(Tax Shield)

- PV(Costs of Financial Distress)


Trade off theory l.jpg
Trade-off Theory

Costs of

financial distress

PV of interest

tax shields

Market Value

Value of levered firm

Value if

All Equity

Debt ratio

Optimal amount

of debt


Costs of financial distress27 l.jpg
Costs of Financial Distress

  • Bankruptcy is not costly in itself; bankruptcy costs are the cost of using this legal mechanism

  • Bankruptcy costs and costs of financial distress are borne by shareholders

    • Creditors foresee the costs and foresee that they will pay them if default occurs

    • For this, they demand higher interest rates in advance

    • This reduces the present market value of shares


Costs of financial distress28 l.jpg
Costs of Financial Distress

  • Direct costs (legal, administrative fees)

    • Manville (1982, asbestos): $200m on fees

    • Eastern Airlines (1989): $114m on fees

    • On average, direct costs = 3% of book assets, or 20% of market equity in year prior to bankruptcy

  • Indirect costs

    • Customers may stray if firm may not be around, suppliers may be unwilling to give much effort to firm’s account, good employees hard to attract …

    • Hard to measure, but probably large


Costs of financial distress29 l.jpg
Costs of Financial Distress

  • US bankruptcy procedures

    Chapter 11

    Aims to rehabilitate firm; protect value of assets while reorganization plan is worked out; used more by large, public companies

    Chapter 7

    Aims to dismember firm; assets are auctioned and creditors paid off (usually) according to seniority; used more by small companies


Costs of financial distress30 l.jpg
Costs of Financial Distress

  • Financial distress may be costly even without formal bankruptcy

  • When a firm is in trouble, both shareholders and bondholders want it to recover, but otherwise their interests may conflict

  • Shareholders may pursue self-interest rather than the usual objective of maximizing overall market value

    • Shareholders may play “games” at creditors’ expense

    • These games can reduce overall value


Financial distress games l.jpg
Financial distress games

Circular File Company has $50 of 1-year debt.


Financial distress games32 l.jpg
Financial distress games

Game #1: Risk shifting

Circular File Company may invest $10 as follows:

  • Suppose NPV of the project is (-$2).

  • What is the effect on the market values?


Financial distress games33 l.jpg
Financial distress games

  • Firm value falls by $2

  • But equity gains $3 (say)


Financial distress games34 l.jpg
Financial distress games

Game #2: Refusing to contribute equity capital

Suppose NPV = $5 project (costs 10 new equity, returns 15)

  • While firm value rises, the lack of a high potential payoff for shareholders actually causes a decrease in equity value.

  • Shareholders will therefore resist the project


Financial distress games35 l.jpg
Financial distress games

Other games

  • Cash In and Run

  • Playing for Time

  • Bait and Switch


Trade off theory redux l.jpg
Trade-off theory redux

  • Trade-off theory argues that optimal debt ratios vary from firm to firm

    • PV (tax shields) vary

      • Depends on level and risk of taxable income

    • PV (costs of financial distress) vary

      • Tangible assets lose least value in distress

      • So can take on more debt

  • So trade-off theory may explain why different firms have different capital structures


Slides by matthew will jeffrey wurgler37 l.jpg

Principles of Corporate Finance

Brealey and Myers Sixth Edition

  • Financing and Valuation

Slides by

Matthew Will, Jeffrey Wurgler

Chapter 19

Irwin/McGraw Hill

  • The McGraw-Hill Companies, Inc., 2000


Topics covered38 l.jpg
Topics Covered

  • After-Tax WACC

  • Using WACC: Tricks of the Trade

  • Adjusting WACC when risks change

  • Adjusted Present Value (APV)


After tax wacc l.jpg
After Tax WACC

  • The tax shield of interest reduces the after-tax weighted-average cost of capital.

  • The amount of the reduction depends on Tc

  • Note WACC < r (our previous “opportunity cost of capital”)


After tax wacc40 l.jpg
After Tax WACC

  • So WACC incorporates the tax advantages of debt financing in lower discount rate

  • Note that all variables in WACC refer to whole firm

    • So after-tax WACC gives right discount rate only for new projects that are just like the firm’s “average”

    • Would need to be adjusted for projects whose acceptance would cause a change in the firm’s overall debt ratio (we’ll show how later)

    • Would need to be adjusted for safer or riskier projects (we won’t show how)


After tax wacc41 l.jpg
After Tax WACC

Example - Sangria Corporation

The firm has a marginal tax rate Tc of 35%. The cost of equity is 14.6% and the pretax cost of debt is 8%. Given the following market value balance sheets, what is the after tax WACC?


After tax wacc42 l.jpg
After Tax WACC

Example - Sangria Corporation - continued

Given:

Tc=35%, rE=.146, rD=.08, and the market value balance sheet:


After tax wacc43 l.jpg
After Tax WACC

Example - Sangria Corporation - continued

Debt ratio = (D/V) = 50/125 = .4

Equity ratio = (E/V) = 75/125 = .6

Plug and chug to solve for WACC …

= .1084


After tax wacc44 l.jpg
After Tax WACC

Example - Sangria Corporation - continued

How to use the WACC of 10.84%?

Suppose company has following investment opportunity: can invest in an ice-crushing machine with perpetual, pretax cash flows of $2.085 million per year.

Given an initial investment of $12.5 million, and assuming that firm will finance it without changing its current debt ratio, what is the value of the opportunity?


After tax wacc45 l.jpg
After Tax WACC

Example - Sangria Corporation - continued

The company would like to invest in a perpetual ice-crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?


After tax wacc46 l.jpg
After Tax WACC

Example - Sangria Corporation – contd.

  • Discount after-tax cash flow (not accounting for debt tax shield) at after-tax WACC. I.e., calculate taxes as if company were all-equity financed.

  • Value of debt tax shield is already being counted in the after-tax WACC!


After tax wacc47 l.jpg
After Tax WACC

  • Interim review:

    After-tax WACC methodology is one way to calculate value when interest is tax-deductible

  • Required assumptions:

    1. Project’s business risks are same as firm average

    2. Project supports the same fraction of D/V as overall firm


Wacc tricks of the trade l.jpg
WACC Tricks of the Trade

What about other forms of financing?

  • Preferred stock (P) and other forms of financing are easily included

  • In this case, V = D + P + E


Wacc tricks of the trade49 l.jpg
WACC Tricks of the Trade

How do you get the inputs?

  • Can use stock market data to estimate rE

  • rD , debt and equity ratios usually easy …

    • … Unless the debt is junk. If default risk is high, promised yield overstates true cost, true expected return

    • No easy solution. (Try sensitivity analysis, see if your choice makes a difference.)


Wacc tricks of the trade50 l.jpg
WACC Tricks of the Trade

Some common mistakes

  • “My firm could borrow 90% of project cost if I want. So D/V=.9, E/V=.1. My firm’s cost of debt is 8%, and cost of equity is 15%. When I discount at WACC = .08*(1-.35)*.9+.15*.1=6.2%, project looks great!”

  • Mistakes:

    • Formula doesn’t apply if project isn’t same as firm. E.g. if firm isn’t already 90% debt financed, can’t use formula without making adjustment.

    • Even if firm was going to lever up to 90% debt, its cost of capital would not decline to 6.2%. The increased leverage would increase the cost of debt and the cost of equity, too.


Wacc for u s oil industry l.jpg
WACC for U.S. oil industry

Percent (nominal)


Wacc y adjustments l.jpg
WACC(y?) adjustments

  • What if project is not financed at same D/E proportions as firm?

  • Can’t just plow ahead with regular WACC. Need to adjust.

  • Three-step process:

    • Calculate opportunity cost of capital using firm debt ratio

      • r = rD(D/V) + rE (E/V)

    • Estimate project cost of debt rD at project debt-equity ratio, and then use this and r to calculate project cost of equity rE

      • rE = r+ (r - rD)(D/E)

    • 3. Recalculate WACC at project rD ,rE , debt ratio


Wacc y adjustments53 l.jpg
WACC(y?) adjustments

  • Sangria contd.

  • What if project supports 20% D/V, not 40% D/V like overall firm?

    • Calculate opportunity cost of capital using firm debt ratio

      • r = rD(D/V) + rE (E/V) = .08(.4) + .146(.6) = .12

    • Estimate project cost of debt rD at project debt-equity ratio, and then use this and r to calculate project cost of equity rE

      • rE = r+ (r - rD)(D/E) = .12 + (.12-.08)(.25) = .13

      • Notes: assumed rD stays at 8%; D/V =.20  D/E = .25

    • Recalculate WACC at project rD ,rE , debt ratio

      • WACC = .08(1-.35)(.2) + .13(.8) = .1140 (vs. .1084 orig.)


Adjusted present value l.jpg
Adjusted Present Value

  • APV is second way to incorporate tax advantages of debt

  • WACC messes around with discount rate, whileAPV explicitly adjusts the cash flows and present values.

    APV = base-case NPV

    + PV(Financing effects)

  • “Base case” = All-equity NPV.

  • “Financing effects” = costs/benefits due to financing

    (interest tax shields, security issue costs)


Adjusted present value55 l.jpg
Adjusted Present Value

Example (financing effect = issue cost):

Project A has a base-case NPV of $150,000. But in order to finance the project we must issue stock, which costs $200,000 in fees.

Project NPV = 150,000

Stock issue cost = -200,000

APV - 50,000

APV < 0  don’t do it


Adjusted present value56 l.jpg
Adjusted Present Value

Example (financing effect = tax shield):

Project B has a base-case NPV of -$100,000. If financed with debt, however, it adds a tax shield with a PV of $140,000.

Project NPV = -100,000

PV(tax shield) = 140,000

APV 40,000

APV > 0  do it (but wouldn’t do it if all-equity)


After tax wacc vs apv l.jpg
After-Tax WACC vs. APV

  • With consistent assumptions, get same answer.

  • WACC assumes constant debt ratio , but then don’t have to value tax shield explicitly 

  • APV lets tax shields vary over time , but have to calculate them yourself .

    • APV more flexible: can handle other financing effects besides interest tax shields 


ad